Opening Remarks

Goldman Slapped

The satraps of Capitol Hill don't have much taste for aggressive financial reform. They do have a certain talent, however, for the theater of aggressive reform. And when Goldman Sachs (GS) CEO Lloyd Blankfein settles in at the witness table of the Senate Permanent Subcommittee on Investigations on Tuesday, that's what they'll try to deliver: a moment that crystallizes three years of global disgust with the smart money boys who seem to have played the rest of us for fools.

When the curtain falls, the case that brought Blankfein to the hot seat—the Securities & Exchange Commission's civil lawsuit alleging that Goldman misled investors when it sold them subprime-mortgage-related investments that were designed to blow up—will still be one small, rotten potato in a large and smelly field. The reforms that might prevent this sort of chicanery will still be elusive. And Goldman, which calls the allegations "completely unfounded" and vows to defend itself "vigorously," will still be the most spectacular cash machine that banking has ever seen.

The SEC chose this case because it is comparatively stark. In early 2007, at the request of Paulson & Co., the hedge fund run by billionaire John Paulson, Goldman structured a deal called Abacus 2007-AC1, designed to let Paulson wager that the subprime-mortgage industry would collapse. Goldman lined up two counterparties for a fee of $15 million: ACA, a bond-insurance company, lost about $950 million (with the banks backstopping it), and a German bank called IKB lost $150 million. Goldman's offense, according to the SEC, was telling IKB that the portfolio of mortgage bonds used for the deal was "selected by ACA," when in fact Paulson was deeply involved in the process, cherry-picking the worst bonds it could find. Goldman didn't tell IKB who was on the other side of the trade, or the extent to which Paulson influenced selections. As a result, the SEC claims, Goldman's statement to IKB was false, misleading, and fraudulent.

The Abacus case is of course far more complex and nuanced than the SEC complaint lets on. This is a cast of characters without a single hero. Not even the supposed victims are sympathetic. IKB sold commercial-paper IOUs to investors in mid-2007 that were worthless by year's end. Its former CEO, Stefan Ortseifen, went on trial last month in Germany for allegedly lying about IKB's financial condition before its near-collapse.

The credit-rating merchants, whose incompetence cannot be overstated, make their usual cameo, as well. And while Paulson didn't get sued, because the SEC said he made no misrepresentations, he did make $1 billion on the deal. Having his name associated with this alleged fleecing carries its own unknowable reputational risk.

The SEC, trying to show that it has grown teeth after doing nothing while Bernie Madoff looted and Lehman Brothers fell to dust, doesn't appear pristine either. Its enforcement chief, Robert Khuzami, until last year was a top lawyer at Deutsche Bank (DB), which, like Goldman, structured transactions for hedge funds betting against subprime bonds. While Khuzami has said he would recuse himself from matters involving Deutsche Bank, he's free to probe its competitors. The SEC filed the suit the same day its inspector general released a horrific report on the agency's decade-long failure to catch accused Ponzi artist Allen Stanford. That PR trick relegated what would have been the day's biggest financial story to the inside pages. The IG's report said the enforcement chief in the Fort Worth office quashed his staff's efforts to investigate, then left for private practice—and landed Stanford as a client. The effrontery of that may well supersede anything Goldman and Paulson are alleged to have done.

The only players in this game that can't speak up for themselves are the synthetic collateralized debt obligations. Their value was tied to the performance of credit-default swaps, derivatives that can be used to protect a bondholder from losses. They're not evil. The problem is they're barely regulated. What's needed are rules to make sure they're used transparently by investors with the capital to absorb losses.

What distinguishes the Abacus case from other doomed subprime deals are the e-mails written by a young Goldman vice-president and now co-defendant, Fabrice Tourre. Had he not typed quite so effusively—"Only potential survivor, the fabulous Fab...standing in the middle of all these complex, highly leveraged, exotic trades"—the SEC might not have had a case and Blankfein might have avoided the hot seat. In one internal Goldman e-mail sent in March 2007, Tourre, now 31, describes the portfolio as "selected by ACA/Paulson." In others, he frets that the housing market might crash before Goldman could close the transaction. Tourre's e-mails may buttress Goldman's basic strategy, which is to cast the SEC's suit as an argument over the conduct of a single employee. "It's all going to be a factual dispute about what he remembers and what the other folks remember on the other side," Greg Palm, Goldman Sachs's co-general counsel, said in a call with reporters on Apr. 20. "If we had evidence that someone here was trying to mislead someone...we'd be the first one to take action."

When Tourre tells his story—which he is expected to do before the same Senate panel that grills Blankfein—he can either support or explode this argument. "If Tourre says, 'Goldman's board knew what we were doing,' you can imagine Goldman will want to portray him as disgruntled," says Onnig Dombalagian, a professor at Tulane University Law School and a former SEC attorney. That may not help the firm itself, he added. "Under theories of vicarious liability, if you can find Tourre liable, it's going to be hard for Goldman to escape."

When Blankfein arrives in Washington, he will find a panel of lawmakers happily getting in touch with their prosecutorial roots. Investigations subcommittee Chairman Carl Levin (D-Mich.) has been using his subprime probe to dig into the complexities of both financial manipulation and human motivation. If Blankfein argues that the buck stopped with Fab, Levin will skewer him. He is not beholden to Goldman.

Levin has subpoena power, and SEC and Justice Dept. personnel detailed to his committee. In addition to Blankfein and Tourre, he is expected to call Goldman executives Craig Broderick, the chief risk officer, and David Viniar, the CFO. One key theme will be inconsistencies between the public record and what Goldman people were saying in private.

One defense Blankfein may emphasize this week could surprise people: Goldman says it got sheared on the Abacus deal. Palm, the co-general counsel, said the firm lost more than $100 million, but the red ink looks awfully convenient. Goldman won't reveal the positions in its mortgage trading book, so there's no way to tell what's real.

If Goldman seems vulnerable to attack, so does an element of the SEC's case—the notion that Tourre misled ACA into thinking Paulson had planned to place a bullish bet when the two were negotiating which mortgages bonds to pick for the CDO.

The Abacus transaction closed on Apr. 26, 2007. By then it was a matter of public record that Paulson had begun profiting on credit derivatives that increased in value as subprime bonds fell. On Mar. 15, Bloomberg News reported that one of Paulson's startup credit funds had gained 67% in eight months. In a letter to his funds' investors quoted by Bloomberg, Paulson wrote: "We believe we are in the early stage of a correction in this market and that the market will eventually implode." The article also quoted him as saying that bad loans made to the riskiest borrowers would "skyrocket" and that "most, if not all, of the independent originators will go bankrupt."

Even the most basic due diligence should have made Paulson's trading strategy clear. That article and others like it can be found with a Google search. ACA and Paulson spent weeks negotiating which bonds would be selected. If each knew the other's intentions, that knocks a hole in the idea that ACA got hustled.

That's a legal matter. What concerns Goldman this week is politics and public relations. It knows how to make money and how to defend those methods in court. What it hasn't been very good at is getting the world to see it the way it sees itself. When Blankfein settles into his chair in Washington, he's hoping what he says will mark the beginning of a long, slow process of turning that perception around.

The timing may not be all bad. Before the SEC's case hit, a certain exuberance had returned to the markets. Big bonuses were back, as was the hot pursuit of risky assets. The spectacle of Blankfein being called upon to explain the actions of an impetuous young man and his bosses should be the spur Wall Street needs to start its own genuine reform process. If ever there were a time to relearn commonsensical standards of behavior and weed out the Fabs before the government comes calling, this is it.